FIN5003 Module 5 financing mix analysis example

Thirty, Fifty or Sixty-Five Percent Debt: What Borrowing Does to the Owners' Return and Risk on a Freezer Facility

Student Name

American College of Education

FIN5003: Financial Decision Making

Module 5 Assignment

Instructor Name

July 31, 2028

The Financing Question

Fenwick, the made-up freezer-warehouse firm this course has followed, has decided in principle to build its $68 million freezer facility, subject to the protections identified in Modules 3 and 4. It must now decide how to pay for it. Its bank has offered term loans at three sizes: 30 percent of cost, $20.4 million, at 6.9 percent; 50 percent, $34 million, at 7.2 percent; or 65 percent, $44.2 million, at 7.9 percent, each amortizing over 20 years. The rest would come from the owners' equity, partly retained earnings and partly a capital contribution from the family. The owners want to know what each choice does to the return on the money they put in and to the risk they bear. Debt does not change how much a freezer earns; it changes who gets paid first and how much is left for the owners when earnings disappoint.

The Theory in Brief

Modigliani and Miller (1958) showed that, in a market without taxes, bankruptcy costs or information problems, a firm's value does not depend on how it is financed: borrowing raises the expected return to equity, but it raises equity's risk by exactly enough to offset the gain. In practice, interest is tax-deductible, which gives debt a value, and heavy borrowing raises the probability and cost of financial distress, which takes value away. The balance between those forces is the trade-off at the heart of capital structure decisions. Myers (1984) added that firms tend to prefer internal funds, then debt, then outside equity, because outsiders know less about the firm than managers do, and that observed capital structures reflect this pecking order as much as any target.

For a family-owned firm like Fenwick, the practical questions are narrower: how much return does borrowing add for the owners, how much risk does it add and at what point would a bad year put the company in trouble with its bank?

Owners' Return and Risk Under Three Scenarios

The analysis uses the facility's operating income in its third year, when occupancy has stabilized, under the three scenarios from Module 4: about $2.3 million in the downside, $4.3 million in the base case and $6.0 million in the upside. Return on the owners' equity is operating income less interest, after tax at 25 percent, divided by the equity invested. With 30 percent debt, the owners invest $47.6 million, pay $1.41 million of interest and earn about 1.4 percent in the downside, 4.6 percent in the base case and 7.2 percent in the upside. With 50 percent debt, they invest $34 million, pay $2.45 million of interest and earn about negative 0.3, 4.1 and 7.8 percent. With 65 percent debt, they invest $23.8 million, pay $3.49 million and earn about negative 3.8, 2.5 and 7.9 percent.

The results contradict a common intuition. More debt does not raise the owners' return in the base case; it lowers it. The reason is that in its third year the facility earns about 4.7 percent on its total cost after tax, less than the after-tax cost of debt of about 5.2 to 5.9 percent. Borrowing magnifies returns only when the assets earn more than the debt costs. It magnifies risk in every case: the spread between the owners' downside and upside returns widens from about 6 points at 30 percent debt to nearly 12 points at 65 percent.

Coverage and the Bank

The bank will test two ratios each year. Interest coverage, operating income divided by interest, is about 3.1 in the base case at 30 percent debt, 1.8 at 50 percent and 1.2 at 65 percent. Debt service coverage, operating cash earnings divided by interest plus principal, must stay above 1.25 under the loan terms. At 30 percent debt, it is about 2.0 in the downside and 2.9 in the base case. At 50 percent, it falls to about 1.2 in the downside, below the covenant. At 65 percent, it is about 1.25 even in the base case and 0.84 in the downside, meaning the facility's cash would not cover its loan payments in a weak year.

Graham and Harvey (2001) found that financial flexibility and credit ratings were among the factors chief financial officers cited most often in deciding how much to borrow. For Fenwick, the equivalent of a credit rating is its standing with its bank, and a covenant breach in the first years of a new facility would cost it flexibility just when it would need it most.

Other Sources the Owners Asked About

The owners asked about three alternatives to bank debt and family equity. The first is a sale-leaseback: selling the finished building to a real estate investor and leasing it back for 20 years. It would return most of the building's cost to Fenwick, but the lease payments would be a fixed obligation much like debt, and Fenwick would lose the building's value in year 20, which Module 3 showed is a large part of the project's worth. The second is equipment financing for the $8.1 million refrigeration system through the manufacturer's finance arm, at a rate slightly above the bank's but without adding to the bank loan or its covenants. That option has merit as a way to preserve bank borrowing capacity, and the controller should obtain terms.

The third is asking the frozen food customer to fund part of the investment, for example by paying for the racking in its space in return for a lower storage rate. Customer funding would reduce Fenwick's investment and tie the customer more closely to the facility, which supports the renewal protection Module 3 required. Its cost is the lower rate, which Module 4 showed the project cannot easily absorb, so any such arrangement must be priced carefully. Consistent with the pecking order Myers (1984) described, the family's retained earnings should be used first, then bank debt at the recommended level, with outside equity or complex structures reserved for needs that cannot be met otherwise.

Recommendation

Fenwick should finance the facility with about 30 percent debt, $20.4 million, consistent with the one-third target used in Module 2's cost of capital. At that level, the owners' return is highest in the base case, positive even in the downside and the bank's covenants hold with room in every scenario. The 50 percent option adds little upside and breaches the debt service covenant in the downside; the 65 percent option would make the facility's survival in a weak year depend on the bank's forbearance.

The recommendation should be revisited as the facility matures. By year 8 or 10, escalating rents and paid-down debt will raise the facility's return on its cost above the cost of debt, and refinancing with more debt could then raise the owners' return without much added risk, returning capital to the family for its next project. The right amount of borrowing depends on what the assets earn and how reliably, and both will change.

References

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7

Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American Economic Review, 48(3), 261-297.

Myers, S. C. (1984). The capital structure puzzle. The Journal of Finance, 39(3), 575-592. https://doi.org/10.1111/j.1540-6261.1984.tb03646.x